Katrina and Fed

Katrina is a supply-side shock event. Oil and other prices will initially have to adjust upward as the aggregate demand remains almost the same and aggregate supply falls. Lowering the rates in this situation will increase the demand even further and prices will go even higher.

Also Katrina’s impact is temporary. Rate changes have long-term effects. Fed should stay the course and keep hiking until excess liquidity is squeezed out, bubbles burst and trade deficit starts shrinking. They should not let a temporary event again change macro-level plans as they did after 9/11.

However, bond market is clearly expecting an end soon. So the question is should Fed take that market expectation into account? If they go against what market wishes, there will be temporary instability which could be dangerous for extremely over-leveraged hedge funds and derivative market. To save them, Fed may take a temporary pause and talk more about the risks, inflationary possibilities and imbalances until the market expectation changes and bond and derivative players reposition themselves.

On top of that, there will be political pressure on Fed to “stimulate” economy and lower rates so that people feel better about their asset wealth and plummeting Bush ratings can recover a bit. 2002 decisions to lower rates and to avoid recession at any cost were more political than economic. Will there be a repeat?

If Fed does decide to pause, it will resume the downtrend of dollar and may even cause a significant correction. Dollar went down a bit last week. Falling dollar and the prospects of stagnant/falling interest rates will make the foreign central banks and foreign investors less interested in continuing to buy US debts. That had started to happen even before Katrina. Now the US government would have to borrow even more to fund the relief work. How long FCBs’ appetite for dollar and support of more US debts would last? Would they continue to care more about the well-being of US consumers than the future of their rapidly expanding and already huge dollar reserves?